The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, June 18, 2011

The Kansas City Fed President and CEO Thomas Hoenig co-authored an article titled "Restructuring the Banking System to Improve Safety and Soundness". He identifies the key to improving safety and soundness

[As the ability of the] market, bank managers and regulators to assess, monitor and/or contain risk taking that endangers the public safety net and financial stability.

Regular readers of this blog know that the ability to assess, monitor and/or contain risk is dependent on having access to all the useful, relevant data in an appropriate, timely manner. Without this data, the market, bank managers and regulators cannot assess, monitor and/or contain risk. Fortunately, accessing this data can be easily done using 21st century information technology.

Mr. Hoenig tries to solve this dependence on data without adopting 21st century information technology.

Instead, he chooses to adopt a new Glass-Steagall that restructures the banking industry by limiting what businesses banks can be in to only those that he thinks are sufficiently transparent to regulators so the regulators can assess, monitor and/or contain risk.

His proposal to restructure the banking industry is identical in impact to the ring-fence, on a stand-alone basis, being proposed by the UK's Independent Banking Commission. Under the ring-fence proposal, certain business activities like deposit taking and lending will be included inside the fence and other business activities like trading will be outside.

Banks with a variety of activities are less transparent. Relative to nonfinancial companies, it is difficult for investors to evaluate the condition of banks and their riskiness because their balance sheet assets and activities are opaque and easily changed [Donald Morgan provides evidence on the increased opacity of banks from combining lending and trading activities in “Rating Banks: Risk and Uncertainty in an Opaque Industry,” American Economic Review, September 2002].

He understands that the market cannot exert discipline since it does not have the necessary data.

Traditional banking is opaque because only the bank knows the risk and quality of its loans.

On-balance sheet traditional banking is opaque because the information has, since the 1930s, historically not been shared with the market, but only with regulators. There is no reason it must remain opaque. In theory, banks are suppose to disclose the risk and quality of their loans when they are bundled into off-balance sheet structured finance securities.

Banks that engage in nontraditional activities such as trading, hedge funds, private equity, and market making are even less transparent because the success of these strategies depend on the confidentiality of the positions and speed with which the banks are able to change their exposures.

It is a feature, not a bug of disclosing to market participants all the useful, relevant data in an appropriate, timely manner that it would make these nontraditional activities less economically attractive.

Given the lack of transparency, regulators must play a larger role relative to the market in monitoring and disciplining banks. However, as already discussed, regulators are also at a disadvantage when dealing with banks engaging in complex activities.

This is the very real problem that was at the heart of the 2008 credit crisis and continues to create enormous financial instability.

This bears repeating.

The market is reliant on the regulators to monitor and discipline the banks. The market cannot monitor and discipline the banks itself because the regulators have an information monopoly on the data needed for monitoring and discipline.

However, and this is the core of the problem, the regulators are not up to the task of monitoring and disciplining the banks. Like the Bank of England's Andrew Haldane, Mr. Hoenig explicitly recognizes this fact.

There are two ways to solve this problem.

Restructure the banking system by limiting the business activities of the banks to those where the capabilities of regulators allow them to assess, monitor and contain risk. However, this does not end the opacity caused by the regulators' information monopoly or the market's dependence on the regulators. The financial system is still subject to financial instability and the potential for a new credit crisis due to errs in regulatory judgment. This solution is preferred by Mr. Hoenig.

End the regulators' information monopoly and provide market participants with access to all the useful, relevant information in an appropriate, timely manner. To do this would require overcoming the opposition of the banks, which should not be too hard given that developed countries cannot afford another crisis, and the adoption of 21st century information technology. This is the solution preferred by your humble blogger.

In making his case for restructuring banks, he identifies the complexity of the universal bank model as the impediment to the market's and the regulator's ability to access all the useful, relevant data in an appropriate, timely manner.

... Overall, the largest financial companies conduct a variety of traditional and non-traditional banking activities, many of which have increased the complexity of their operations and portfolios.

These companies benefit from additional activities, for example, if they increase the diversification of their assets and revenue streams. However, these benefits are outweighed by the significant complications it poses for the market, bank management, and regulators to assess, monitor, and/or contain risk taking that endangers the public safety net and financial stability.

Specifically, as explained below, combining banking and nonbanking activities makes it more difficult to supervise and regulate banks, to price deposit insurance, and for bank management to manage risks. It also reduces market discipline by making banks less transparent.

In a nutshell, a member of the Fed's Open Market Committee has summarized the problems caused by opacity in the regulated banking system. Because of his focus on banks, he leaves out the problems caused by opacity in the unregulated banking system.

Some activities make it more difficult to supervise banks. The goal of prudential supervision is to control bank risk taking so that they are safe and sound and do not endanger the safety net. This is done by monitoring a bank’s financial condition, lending, operational, risk management, and other practices and enforcing regulatory rules.

Due to the periodic nature of bank supervision, supervisors are able to get only a snapshot of bank processes, risk exposure, and capital positions at a given point in time. These snapshots are useful only as long as they are able to predict the bank’s processes, risk exposure, and capital positions between the supervisory examinations. The flexibility to adjust risk profiles between exams depends to some extent on the activities banks engage in and the nature of the risks.

Mr. Hoenig implies that the bank supervisors embedded on-site for the large, complex banking organizations are not actively monitoring what is happening. The Wall Street Journal carried a long article on how embedded regulators are monitoring what is happening in essentially real-time.

Many of the nontraditional activities that the large, complex banking organizations engage in are difficult to supervise effectively because they are very risky in the short term and can be used to quickly change a bank’s risk profile.

For example, trading and market-making are high frequency activities that can take place between exams with little evidence that they ever occurred. As a result, a snapshot of positions of these activities on one day has no predicative value for the positions, for example, a week later.

Monitoring these activities on a high-frequency basis would be very costly for banks and supervisors. Moreover, it requires substantial transparency that banks are likely to strongly oppose. Thus, while examiners may err in their judgment on the riskiness of any activity, they do not have the tools to monitor the riskiness of many traditional non- banking activities.

Mr. Hoenig asserts that monitoring these activities on a high frequency basis is very costly. This is an important assertion because it drives his conclusion that banks need to be restructured so they only have what he views as transparent activities.

Is there any evidence that providing market participants access to all the useful, relevant data in an appropriate, timely manner for high frequency activities and subsequently monitoring these activities is very costly?

No. In fact, a great deal of work has been done showing that the economic benefits of providing market participants access to all the useful, relevant data in an appropriate, timely manner are multiples of any expenses incurred in providing the data. This blog has highlighted examples of this work.

As discussed in one post, Bank of England's Andrew Haldane estimated the minimum loss from the 2008 credit crisis to be $4 trillion. This was before factoring in broader social costs like unemployment and business failure. Including these drives the estimated loss from the credit crisis up by a factor of 10. The low-end of this loss range was then compared to the multi-billion dollar cost to provide and use this information on an annual basis. The conclusion based on this cost/benefit analysis was that it makes sense to provide and use this information to minimize the risk of incurring trillions of dollars of losses again.

As discussed in a different post, the cost of providing transparency for a single security was compared to the increase in value of the security that results from the elimination of opacity. It is a basic tenet of finance that the lower the risk of a security, the lower the return required by investors to own the security. In theory, removing opacity, a form of risk, should lower the investors' required rate of return. Structured finance securities were used as an example. The annual cost of providing transparency is approximately 5 basis points (0.05%). The annual savings from the elimination of the opacity related illiquidity premium (there is a limited secondary market since without transparency it is difficult for a potential new buyer to analyze the security and know what they are buying) is at least 25 basis points (0.25%). The conclusion based on this cost/benefit analysis was that it makes sense to provide this information for the market to use.

Mr. Hoenig assets that banks are going to strongly oppose transparency. This is an important assertion because it is used as justification for not requiring transparency, but instead arguing for restructuring the banks.

Is there any reason to believe that banks will strongly oppose transparency?

... opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the [financial firms'] innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

Regular readers know that under the FDR Framework the government is responsible for [and in the US regulators already have the legislative authority for] ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner.

Opposition by the banking industry is to be both expected and ignored if the government is going to fulfill its responsibility and/or legislative authority.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.